Determining number of owners for entity classification elections.

• Author: Perez, Ruth

Since the introduction of the "disregarded entity" classification in the early 1990s, taxpayers have had substantial flexibility in selecting the classification of an entity for tax purposes and, hence, how they can treat the entity. However, some taxpayers may not realize the complex determinations they may have to make to achieve the desired result.

Some classification limits found in Regs. Sec. 301.7701-3(a) depend on the number of owners and the nature of ownership, which may require an exacting inquiry. For example, for foreign entities, it is necessary to determine whether the owner of an entity has limited liability (i.e., the owner has no personal liability for the debts of or claims against the entity). That determination is made under the local law where the owner was organized.

As to the number of owners, Regs. Sec. 301.7701-3(a) provides in part:

An eligible entity with at least two members can elect to be classified as either an association ... or a partnership, and an eligible entity with a single owner can elect to be classified as an association or to be disregarded as an entity separate from its owner.

Although that general rule seems straightforward, its application may jeopardize the validity of a classification election made on Form 8832, Entity Classification Election, because an improper classification may be made based on the number of owners. If invalid, an election may generally be remedied only through requesting relief from the I1KS either under 1Kev. Proc. 2002-59 (for initial elections effective on the date of formation) or under Regs. Sec. 301.9100-1 (a formal letter ruling request).

Tax Classification

When "counting" the number of owners, it is not sufficient merely to base that determination on the number of legal owners of the entity. Instead, it is necessary to determine the Federal tax classification of the owner entity or entities. According to Rev. Rul. 2004-77, if an eligible entity has two legal owners, one of which is disregarded as an entity separate from the other owner, the eligible entity has only one owner and, thus, cannot be a partnership. Instead, the eligible entity either may be disregarded as an entity separate from its owner or is an association taxable as a corporation.

Example: Two partners of a domestic...